How Private Equity Funds Work

Private equity funds are investment vehicles that pool together capital from accredited investors to acquire ownership stakes in private companies or, sometimes, public companies that are taken private. These funds aim to generate high returns by improving the businesses they invest in and eventually selling them for a profit. Private equity funds are typically closed-end, meaning investors commit their capital for a fixed period, traditionally up to 10 years, during which the fund’s management invests the funds, manages portfolio companies and arranges an exit.

A financial advisor can work with you to determine if investing in a private equity fund could help you reach your financial goals.

What Are Private Equity Funds?

Private equity funds are investment vehicles managed by professionals that acquire ownership stakes in private companies. They may also purchase public companies with the intention of taking them private. These funds are primarily managed by private equity firms , which raise capital from institutional investors like pension funds, endowments and high-net-worth individuals .

The primary objective of a private equity fund is to find undervalued or underperforming companies, enhance their operations and eventually sell them for a profit. These funds often focus on companies that require operational improvements, additional capital, or strategic guidance to reach their full potential. As a result, private equity managers actively engage with their portfolio companies, often taking positions on the board of directors or influencing key business decisions.

Investors in private equity funds typically do not have a say in the specific investments made by the fund managers. Instead, they entrust their capital to these managers, who are responsible for making investment decisions. This structure allows the managers to pursue opportunities that align with the fund’s overall strategy, aiming to generate returns for their investors.

How Do Private Equity Funds Work?

Private equity funds work by raising capital commitments from investors and deploying that capital to acquire controlling or significant minority stakes in companies. Once a private equity fund identifies a target company, the fund purchases equity in that company, often leveraging the investment with debt to maximize returns. After acquiring the company, the private equity fund  works to improve the business’s operations, enhance profitability and position it for future growth.

For example, a fund may purchase a family-owned manufacturing business that has struggled with improving its efficiency. The fund may hire new management, streamline operations and invest in modernizing the company’s facilities. After five years of implementing these improvements, the private equity fund might sell the company to a larger corporation or take it public.

Throughout the process, the private equity firm charges management fees and also takes a percentage of the profits, known as carried interest , once the investment has been successfully sold. Investors in the fund typically see returns after the investment has been sold, meaning private equity investments often require a long-term commitment and patience.

How to Invest in a Private Equity Fund

If you're interested in investing in a private equity fund, here are five general steps to help you get started:

• Meet accreditation requirements: For a private equity fund to accept your investment,  you must typically be an accredited investor . This means meeting certain financial criteria, such as having a net worth excluding your primary residence of at least $1 million or earning an annual income of at least $200,000. Private equity investments are generally not available to most retail investors because of the high risks and illiquidity involved. You may have to document your financial status before the fund will permit investment.
• Research private equity firms: Before investing, research the firm's track record and strategy. Look for firms with a history of successful investments and strong management teams. It's also wise to review the sectors the firm focuses on.
• Review the fund's prospectus: Once you’ve identified a private equity firm, read the prospectus or offering memorandum for the specific fund you’re interested in. This document outlines the fund's strategy, target investments, fees and potential risks. It’s important to thoroughly understand the terms before committing capital.
• Commit capital: When you decide to invest, you will commit a certain amount of capital that the private equity firm will call upon as investment opportunities arise. Unlike public market investments, you do not invest all your capital upfront. Instead, the firm will call or request the actual cash from investors as it identifies companies to invest in.
• Monitor the investment: Private equity investment requires patience as there is often a long holding period. During this time, the private equity firm will manage the portfolio companies, make improvements and eventually seek to sell or exit the investments. Investors receive updates on the performance of the fund, but returns are typically realized only after an exit, which could take several years.

Frequently Asked Questions About Private Equity Funds

What Are the Fees Associated With Private Equity Funds?

Private equity funds usually charge two types of fees: 1. The management fee is typically 1-2% of the committed capital, paid annually. 2. Carried interest is a percentage of the profits, usually around 20%, that the private equity firm takes once an investment is sold for a profit.

How Long Is the Investment Horizon for Private Equity Funds?

Private equity funds generally have a long investment horizon, often lasting seven to 10 years. Investors should be prepared for their capital to be unavailable during this period, as returns are typically realized at the end of the holding period when investments are sold or exited.

Are Private Equity Funds Risky?

Yes, private equity funds come with a higher level of risk compared to more traditional investments. The use of leverage, the illiquid nature of the investments and the reliance on the private equity firm's ability to improve the companies all contribute to the risk. However, with higher risk comes the potential for higher returns.

Bottom Line

Private equity funds offer an opportunity for accredited investors to gain exposure to private companies with the potential for high returns. By investing in these funds, investors can benefit from the expertise of private equity managers who actively work to improve portfolio companies and generate profit. However, investing in private equity requires a long-term commitment and comes with significant risk.

Tips for Investments

• A financial advisor can help you analyze investments and manage risks for your portfolio. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you sell an asset for more than what you paid, you may owe capital gains taxes. SmartAsset's capital gains tax calculator can help you estimate how much you could pay in taxes .

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